IFRS 3, Business Combinations was issued in January 2008 as the second phase of a

joint project with the Financial Accounting Standards Board (FASB), the US standards
setter, and is designed to improve financial reporting and international convergence in
this area. The standard has also led to minor changes in IAS 27, Consolidated and
Separate Financial Statements. The requirements of the revised IFRS 3 have been
examinable since December 2008. This article relates to the relevance of IFRS 3 to
Paper F7, Financial Reporting.

This article is also of interest to candidates studying UK-based papers, as under UK

regulation consolidated goodwill is calculated using the non-controlling interest’s (NCI)
proportionate share of the subsidiary’s identifiable net assets (referred to as method (ii)
below).

The revised IFRS 3 introduces:

 Restrictions on the expenses that can form part of the acquisition costs
 New principles for the treatment of contingent consideration
 A choice in the measurement of non-controlling interests (which have a knock-on
effect to consolidated goodwill), considerable guidance on recognising and measuring
the identifiable assets and liabilities of the acquired subsidiary, in particular the
illustrative examples discuss several intangibles, such as market-related, customer-
related, artistic-related and technology-related assets.

Acquisition costs

All acquisition costs, even those directly related to the acquisition such as professional fees
(legal, accounting, valuation, etc), must be expensed. The costs of issuing debt or equity are
to be accounted for under the rules of IAS 39, Financial Instruments: Recognition and
Measurement.

Contingent consideration

IFRS 3 defines contingent consideration as: ‘Usually, an obligation of the acquirer to transfer
additional assets or equity interests to the former owners of an acquiree as part of the
exchange for control of the acquiree if specified future events occur or conditions are met.
However, contingent consideration also may give the acquirer the right to the return of
previously transferred consideration if specified conditions are met’ (this would be an asset).

IFRS 3 requires the acquirer to recognise any contingent consideration as part of the
consideration for the acquiree. It must be recognised at its fair value which is ‘the amount for
which an asset could be exchanged, or a liability settled, between knowledgeable, willing
parties in an arm’s length transaction’. This ‘fair value’ approach is consistent with the way
in which other forms of consideration are valued. Applying this definition to contingent
consideration may not be easy as the definition is largely hypothetical; it is highly unlikely
that the acquisition date liability for contingent consideration could be or would be settled by
‘willing parties in an arm’s length transaction’. An exam question would give the fair value
of any contingent consideration or would specify how it is to be calculated. The payment of
contingent consideration may be in the form of equity, a liability (issuing a debt instrument)
or cash.
If there is a change to the fair value of contingent consideration due to additional information
obtained after the acquisition date that affects the facts or circumstances as they existed at the
acquisition date, it is treated as a ‘measurement period adjustment’ and the contingent
liability (and goodwill) are remeasured. This is effectively a retrospective adjustment and is
rather similar to an adjusting event under IAS 10, Events After the Reporting Period. Changes
in the fair value of contingent consideration due to events after the acquisition date (for
example, meeting an earnings target which triggers a higher payment than was provided for
at acquisition) are treated as follows:

 Contingent consideration classified as equity shall not be remeasured, and its

subsequent settlement shall be accounted for within equity (eg Cr share capital/share
premium Dr retained earnings).
 Contingent consideration classified as an asset or a liability that:
– is a financial instrument and is within the scope of IAS 39 shall be measured at fair
value, with any resulting gain or loss recognised either in the statement of profit or
loss, or in other comprehensive income in accordance with that IFRS
– is not within the scope of IAS 39 shall be accounted for in accordance with IAS 37,
Provisions, Contingent Liabilities and Contingent Assets, or other IFRSs as
appropriate.

Note that although contingent consideration is usually a liability, it may be an asset if the
acquirer has the right to a return of some of the consideration transferred if certain conditions
are met.

Goodwill and non-controlling interests

The acquirer (parent) measures any non-controlling interest either:

1. at fair value as determined by the directors of the acquiring company (often called the
‘full goodwill’ method); or
2. at the non-controlling interest’s proportionate share of the acquiree’s (subsidiary’s)
identifiable net assets (this is the UK method).

The differential effect of the two methods is that (i) recognises the whole of the goodwill
attributable to an acquired subsidiary, whereas (ii) only recognises the parent’s share of the
goodwill.

EXAMPLE 1
Parent pays $100m for 80% of Subsidiary which has net assets with a fair value of $75m. The
directors of Parent have determined the fair value of the NCI at the date of acquisition was
$25m.

Method (i) Consideration $

Parent 100
NCI 25
125
 Fair value of net assets (75)
Consolidated goodwill on acquisition
50

In the consolidated statement of financial position the non-controlling interests would be

shown as $25m.

In the above example the value of the non-controlling interests of $25m as determined by the
directors of Parent is proportionate to that of Parent’s consideration ($100m x 20%/80%).
This is not always (in fact rarely) the case.

Method (ii) Consideration $

Parent 100
Share of fair value of net assets acquired

($75m x 80%) (60)

Consolidated goodwill 40

In the consolidated statement of financial position the non-controlling interest would be

shown at its proportionate share of the subsidiary’s net assets of $15m ($75m x 20%).

The two methods are an extension of the methodology used in IAS 36, Impairment of
Assets when calculating the impairment of goodwill of a cash generating unit (CGU) where
there is a non-controlling interest.

EXAMPLE 2
Parent owns 80% of Subsidiary (a CGU). Its identifiable net assets at 31 March 2010 are
$500.

Scenario 1

$
Net assets included in the consolidated statement of financial position
500
Consolidated goodwill
(calculated under method (i)) 200
700

NCI 140

Scenario 2

$
Net assets included in the consolidated statement of financial position 500
 $
Consolidated goodwill
(calculated under method(ii)) 160
660

NCI 100

An impairment review of Subsidiary was carried out at 31 March 2010.

Required:
For scenarios 1 and 2, calculate the impairment losses and show how they would be
allocated if the recoverable amount of Subsidiary at 31 March 2010 if the impairment
review concluded that the recoverable of Subsidiary was:
(i) $450
(ii) $550

Answer

Scenario 1
The impairment loss is $250 (700 – 450). This loss will be first applied to goodwill
(eliminating it) and then to the other net assets reducing them to $450, ie equal to the
recoverable amount of the CGU. The statement of financial position would now be:

$
Net assets (to be consolidated) 450
Consolidated goodwill nil
450

NCI (140 – (250 x 20%)) (see below)) 90

Note: IFRS 3 requires that any impairment loss should be written of to the controlling and
non-controlling interests on the same basis as that in which profits loss are allocated.

With a recoverable amount of $550, the impairment loss will be $150 and applied to the
goodwill reducing it to $50. The statement of financial position would now be:

$
Net assets (to be consolidated) 500
Consolidated goodwill (under method (i)) 50
550

NCI (140 – (150 x 20%)) 110

Scenario 2
Where method (ii) has been used to calculate goodwill and the non-controlling interests, IAS
36 requires a notional adjustment to the goodwill of Subsidiary, before being compared to the
recoverable amount. This is because the recoverable amount relates to the value of Subsidiary
as a whole (ie including all of its goodwill). The notional adjustment is always based on the
non-controlling interest in goodwill being proportional to that of the parent.

Goodwill Net assets Total

$ $ $
Carrying amount –
re Parent 160 500 660
Notional adjustment re NCI (see below)
40 40
200 500 700

If the goodwill of Parent is $160 and this represents 80%, then the goodwill attributable to the
NCI is deemed to be $40 ($160 x 20%/80%).

In this case, because the fair value of the non-controlling interests in scenario 1 is
proportional to the consideration paid by Parent, the notional adjustment leads to the same
impairment losses of $450 for (i) and $550 for (ii) as under scenario 1 (see *). Applying
these:

(i) the impairment loss of $250 is again applied to eliminate goodwill and the remaining $50
is applied to reduce the other net assets. The non-controlling interest will be reduced by $10
being its share (20%) of the reduction of other net assets. This gives exactly the same
statement of financial position as under scenario 1.

$
Net assets (to be consolidated) 450
Consolidated goodwill nil
450

NCI (100 – 10 (50 x 20%)) 90

(ii) the impairment loss of $150 would be applied to goodwill leaving the other net assets
unaffected. As only Parent’s share of goodwill is recognised, only 80% of the loss is applied,
giving:

$
Net assets 500
Goodwill (160 – (150 x 80%)) 40
540

NCI (unaffected) 100

From this it can be seen that the carrying amount of the CGU is now $540, which is less than
the recoverable amount ($550) of the CGU. This is because the recoverable amount takes into
account the unrecognised goodwill of the NCI which would be $10 (goodwill of $200 – $150
impairment) x 20%).
The problem with this methodology is that goodwill (or what is subsumed within it) is a very
complex item. If asked to describe goodwill, traditional aspects such as product reputation,
skilled workforce, site location, market share, and so on, all spring to mind. These are
perfectly valid, but in an acquisition, goodwill may contain other factors such as a premium
to acquire control, and the value of synergies (cost savings or higher profits) when the
subsidiary is integrated within the rest of the group. While non-controlling interests may
legitimately lay claim to their share of the more traditional aspects of goodwill, they are
unlikely to benefit from the other aspects, as they relate to the ability to control the
subsidiary.

*Thus, it may not be appropriate to value non-controlling interests on the same basis
(proportional to) as the controlling interests (see method (i) below).

IFRS 3 illustrates the calculation of consolidated goodwill at the date of acquisition as:

Consideration paid by parent + non-controlling interest – fair value of the subsidiary’s net
identifiable assets = consolidated goodwill.

The non-controlling interest in the above formula may be valued at its fair value (method (i))
or its proportionate share of the subsidiary’s net identifiable assets (method (ii)).

Subsequent to acquisition the carrying amount of the non-controlling interest (under either
method) will change in proportion it is share of the post acquisition profits or losses of the
subsidiary. Consolidated goodwill (under either method) will remain the same unless
impaired.

The standard recognises that there may be many ways of calculating the fair value of the non-
controlling interest (method (i)), one of which may be to use the market price of the
subsidiary’s shares prior to the acquisition (where this exists). In the Paper F7 exam this is
the most common method; an alternative would be to simply give the fair value of the non-
controlling interests in the question.

EXAMPLE 3
This comprehensive example is an adaptation of Question 1 from the December 2007 Paper
F7 (INT) paper, and calculates goodwill based on the fair value of the non-controlling
interests (method (i) above) by valuing the non-controlling interests using the subsidiary’s
share price at the date of acquisition (see note (iv) of the question).

On 1 October 2006, Plateau acquired the following non-current investments:

Three million equity shares in Savannah by an exchange of one share in Plateau for every two
shares in Savannah, plus $1.25 per acquired Savannah share in cash. The market price of each
Plateau share at the date of acquisition was $6, and the market price of each Savannah share
at the date of acquisition was $3.25.

Thirty per cent of the equity shares of Axle at a cost of $7.50 per share in cash.

Only the cash consideration of the above investments has been recorded by Plateau. In
addition, $500,000 of professional costs relating to the acquisition of Savannah are included
in the cost of the investment.
The summarised draft statements of financial position of the three companies at 30
September 2007 are:

Plateau Savannah Axle

$000 $000 $000
Assets
Non-current assets:
Property, plant and equipment
18,400 10,400 18,000
Investments in Savannah and Axle
13,250 nil nil
Financial asset investments
6,500 nil nil
38,150 10,400 18,000
Current
assets:
Inventory 6,900 6,200 3,600
Trade
receivables 3,200 1,500 2,400
Total assets 48,250 18,100 24,000
Equity and liabilities
Equity shares of $1 each 10,000 4,000 4,000
Retained earnings
- at 30 September 2006 16,000 6,000 11,000
- for year ended
30 September 2007 9,250 2,900 5,000
Total assets 35,250 12,900 20,000
Non-current liabilities
7% loans 5,000 1,000 1,000
Current liabilities 8,000 4,200 3,000
Total equity and liabilities 48,250 18,100 24,000

The following information is relevant:

(i) At the date of acquisition, Savannah had five years remaining of an agreement to supply
goods to one of its major customers. Savannah believes it is highly likely that the agreement
will be renewed when it expires. The directors of Plateau estimate that the value of this
customer based contract has a fair value of $1m, an indefinite life, and has not suffered any
impairment.

(ii) On 1 October 2006, Plateau sold an item of plant to Savannah at its agreed fair value of
$2.5m. Its carrying amount prior to the sale was $2m. The estimated remaining life of the
plant at the date of sale was five years (straight-line depreciation).
(iii) During the year ended 30 September 2007, Savannah sold goods to Plateau for $2.7m.
Savannah had marked up these goods by 50% on cost. Plateau had a third of the goods still in
its inventory at 30 September 2007. There were no intra-group payables/receivables at 30
September 2007.

(iv) At the date of acquisition the non-controlling interest in Savannah is to be valued at its
fair value. For this purpose Savannah’s share price at that date can be taken to be indicative
of the fair value of the shareholding of the non-controlling interest. Impairment tests on 30
September 2007 concluded that neither consolidated goodwill nor the value of the investment
in Axle had been impaired.

(v) The financial asset investments are included in Plateau’s statement of financial position
(above) at their fair value on 1 October 2006, but they have a fair value of $9m at 30
September 2007.

(vi) No dividends were paid during the year by any of the companies.

Required:
Prepare the consolidated statement of financial position for Plateau
as at 30 September 2007. (20 marks)

Tutorial note
Note (iv) may instead have said that the fair value of the NCI at the date of acquisition was
$3,250,000. Alternatively, it may have said that the goodwill attributable to the NCI was
$500,000. All these are different ways of giving the same information.

Answer
Consolidated statement of financial position of Plateau as at 30 September 2007:

$000 $000
Assets
Non-current assets
Property, plant and equipment
(18,400 + 10,400 – 400 (w (i))) 28,400
Goodwill (w (ii)) 5,000
Customer-based intangible 1,000
Investments
– associate (w (iii)) 10,500
– financial asset 9,000
53,900
Current assets:
Inventory (6,900 + 6,200
– 300 URP (w (iv))) 12,800
4,700 17,500
Total assets 71,400

Equity and liabilities

Equity attributable to equity holders of the parent
 $000 $000
Equity shares of $1 each (w (v)) 11,500
Reserves
Share premium (w (v)) 7,500
Retained earnings (w (vi)) 30,300 37,800
49,300
Non-controlling interest (w (vii)) 3,900
Total equity 53,200

Non-current liabilities
7% Loan notes (5,000 + 1,000) 6,000

Current liabilities
(8,000 + 4,200) 12,200
Total equity and liabilities 71,400

Workings (figures in brackets are in $000).

(i) Property, plant and equipment

The transfer of the plant creates an initial unrealised profit (URP) of $500,000. This is
reduced by $100,000 for each year (straight-line depreciation over five years) of depreciation
in the post-acquisition period. Thus at 30 September 2007, the net unrealised profit is
$400,000. This should be eliminated from Plateau’s retained profits and from the carrying
amount of the plant.

(ii) Goodwill in Savannah

$000 $000
Controlling interest:
Shares issued (3,000/2 x $6) 9,000
Cash (3,000 x $1.25) 3,750
12,750
Non-controlling interests
(1 million shares at $3.25) 3,250
Total consideration 16,000

Equity shares of Savannah 4,000

Pre-acquisition reserves 6,000
Customer-based contract 1,000 (11,000)
Consolidated goodwill 5,000

Tutorial note

The consideration given by Plateau for the shares of Savannah works out at $4.25 per share,
ie consideration of $12.75m for 3 million shares. This is higher than the market price of
Savannah’s shares ($3.25) before the acquisition and could be argued to be the premium paid
to gain control of Savannah. This is also why it is (often) appropriate to value the NCI in
Savannah shares at $3.25 each, because (by definition) the NCI does not have control.

(iii) Carrying amount of Axle at 30 September 2007

$000
Cost (4,000 x 30% x $7.50) 9,000
Share post-acquisition profit (5,000 x 30%)
1,500
10,500

(iv) The unrealised profit (URP) in inventory Intra-group sales are $2.7m on which Savannah
made a profit of $900,000 (2,700 x 50/150). One third of these are still in the inventory of
Plateau, thus there is an unrealised profit of $300,000.

(v) The 1.5 million shares issued by Plateau in the share exchange, at a value of $6 each,
would be recorded as $1 per share as capital and $5 per share as premium, giving an increase
in share capital of $1.5m and a share premium of $7.5m.

(vi) Consolidated return earnings

$000
Plateau’s retained earnings 25,250
Professional costs of acquisition
must be expensed (500)
Savannah’s post-acquisition
(2,900 – 300 URP) x 75% 1,950
Axle’s post-acquisition profits
(5,000 x 30%) 1,500
URP in plant (see (i)) (400)
Gain on financial asset investments
(9,000 – 6,500) 2,500
30,300

(vii) NCI

Fair value at acquisition 3,250

Post-acquisition profit (2,900 – 300 URP) 650
3,900

Note that subsequent to the date of acquisition, the non-controlling interest is valued at its fair
value at acquisition plus its proportionate share of Savannah’s (adjusted) post acquisition
profits.

Further issues
The original question contained an impairment of goodwill; let’s say that this is $1m. IAS 36
(as amended by IFRS 3) requires a goodwill impairment of a subsidiary (if a cash generating
unit) to be allocated between the parent and the non-controlling interests in on the same basis
as the subsidiary’s profits and losses are allocated. Thus, of the impairment of $1m, $750,000
would be allocated to the parent (and debited to group retained earnings reducing them to
$29.55m ($30,300,000 – $750,000)) and $250,000 would be allocated to the non-controlling
interests, writing it down to $3.65m ($3,900,000 – $250,000). It could be argued that this
requirement represents an anomaly. It can be calculated (though not done in this example)
that of Savannah’s recognised goodwill (before the impairment) of $5m only $500,000 (ie
10%) relates to the non-controlling interests, but the NCI suffers 25% (its proportionate
shareholding in Savannah) of the goodwill impairment.

Written by a member of the Paper F7 examining team